Is There Any Hope for Retailers?

The state of the consumer is the hot button issue these days on the presidential campaign trail, as the so called "oil crisis" reaches mass hysteria. No, we haven't arrived at the point of gasoline rationing or siphoning petrol from a neighbor's GMC Yukon, but if prices stay at presently bubble-ish levels then the latter is certainly an option. While some individuals dust off their siphon hoses, or used Starbucks straws perhaps, the angst is particularly elevated for the nation's retailers. You see, companies selling products ranging from juice boxes to weather sensitive apparel are about to enter the critical demand periods of back to school and the holidays. This year got off on an inauspicious note as waning demand for discretionary goods led many retailers to bite the profit bullet and enact what can be characterized as panic markdowns. Surely, this was welcome news for cash starved consumers, but was an unwelcome set of circumstances for retailers.

We have been generally pleased with how consumer spending has trended in recent months, a trend that has been helped by still over indulgent lifestyles and by the arrival of economic stimulus checks. Whether stimulus check spending correlates into a reasonably profitable back to school selling season is anyone's guess, but we would not be shocked if consumers demonstrate a propensity to purchase goods other than $4.00 a gallon gasoline (latest read on retail sales fleshes out consumer resilience to macro forces).

As a result of the high degree of uncertainty, retail stocks have traded with very little conviction since mid-March, despite most of them fetching valuation multiples near or well below historical norms. There is no need to load up on the sector in some kind of "bottom" call, since in all likelihood consensus earnings estimates for 2Q, 3Q, and 4Q will be revised lower shortly as summer product markdowns spook the analyst community.

Rather, we advocate a disciplined approach to investing in the sector, with a focus on companies that have controlled inventories, are gaining market share, and have a compelling story. Meeting this selection criteria is Aeropostale Inc. (ARO), Children's Place Inc. (PLCE), Urban Outfitters Inc. (URBN), Tiffany & Co. (TIF), and Hot Topic Inc. (HOTT). For these companies, we have noticed a consistent rise in earnings estimates for 2008 and 2009, fueled in large part by strengthening demand and prospect for accelerating margins.

Written by Brian Sozzi, a Research Analyst for Wall Street Strategies (www.wstreet.com) specializing in the apparel/hardline goods sectors of the retail industry.